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Investment Overview for Norfolk Southern (NYSE:NSC)
WHAT HAS CHANGED
Two important factors have impacted the business prospects of railroad companies, such as Norfolk Southern, over the past few quarters -- weak fuel prices and declining coal shipments. Weak fuel prices and declining coal shipments have negatively impacted the company's operations.
- Weak fuel prices have negatively impacted operations
- Crude oil prices have weakened considerably over the course of the last twelve months, as a result of a global supply glut. This has negatively impacted the fuel surcharge revenues for Norfolk Southern, which are tied to either WTI crude oil prices or On-Highway diesel prices. However, low fuel prices have also helped reduce operating costs, which has partially offset the negative impact of weak fuel surcharge revenues, and declining coal shipments on the company's results. As a result, the company's operating ratio (operating costs as a % of operating revenues) worsened by only 250 basis points year-over-year in the first half of 2015, despite the 8% reduction in revenues.
- Declining coal shipments
- A combination of an adverse regulatory environment and weak natural gas prices has undermined the demand for coal. As a part of the federal government's broader plans to reduce carbon dioxide emissions, it is targeting a 32% reduction in power plant carbon dioxide emissions from 2005 levels, by 2030. Since coal based thermal power plants have higher emissions intensity as compared to natural gas based thermal power plants, the prevailing regulatory environment favors natural gas, instead of coal, as the preferred fuel for electricity generation. In addition, weak natural gas prices have accelerated the shift towards natural gas as the preferred fuel for electricity generation. These developments have lowered the demand for coal, which has negatively impacted Norfolk Southern's coal shipments, which declined 15% in the first half of 2015.
Below are the key drivers of Norfolk Southern's value that present opportunities for upside or downside to the current Trefis price estimate:
- Norfolk Southern's EBITDA margin: We currently forecast Norfolk Southern's EBITDA margin to increase from 38.3% in 2013, to 42%, by the end of the Trefis forecast period. We expect the EBITDA margin to rise slightly in 2013 on account of the negative mix in price caused by growth in the low RPU businesses.
The coal freight services business is a profitable segment of Norfolk Southern due to its highly efficient unit train configurations and longer-than-average lengths of haul, which helps commands high yields. The intermodal segment, although less profitable than the coal freight segment, carries high incremental margins, as the incremental costs of increasing train lengths are low.
The recent double-stack initiatives further provides an upside to margins.
Productivity improvements partly depend on volume growth and the expected margin gains are easier to reach should we see healthy volume growth over the next few years.
There could be a downside of approximately 15% to the Trefis price estimate if the volume growth is below expectations due to lower than expected economic growth, and the EBITDA margin declines to 36% by the end of the Trefis forecast period.
- Revenue per Carload of Coal Freight:
We currently forecast the coal freight revenue per carload to increase substantially, reaching $2,145 by the end of the Trefis forecast period, from $1,888 in 2013.
There could be a downside of nearly 5% to the Trefis price estimate if the revenue per carload of coal freight decreases to $1,800 by the end of the Trefis forecast period.
- Revenue per Intermodal Unit:
We currently forecast the revenue per intermodal unit to increase substantially, reaching $800 by the end of the Trefis forecast period from $667 in 2013, because of tighter truckload capacity, thereby causing truck-to-rail conversions. This is in addition to the ongoing corridor projects, which improve capacity, service, reliability, and efficiency, thereby providing operating leverage.
If the revenue per thousand ton-miles for intermodal freight increases marginally, reaching $700 by the end of the Trefis forecast, then there could be a downside of around 4% to the Trefis price estimate.
For additional details, select a driver above or select a division from the interactive Trefis split for Norfolk Southern at the top of the page.
Norfolk Southern Corporation is one of the largest railroad companies in the Eastern United States, engaged primarily in the rail transportation of raw materials, intermediate products, and finished goods. Goods are primarily transported in the Southeast, East, and Midwest US, and via interchange services with rail carriers, to and from the rest of the United States. Norfolk Southern also transports overseas freight through several Atlantic and Gulf Coast ports.
Its principal subsidiary, Norfolk Southern Railway Company
is wholly owned. NSC also has a joint ownership, along with CSX, of the Consolidated Rail Corporation. Norfolk Southern's route map covers most of the eastern United States, east of the Mississippi River, the District of Columbia, and the Canadian provinces of Ontario and Quebec, covering nearly 22 states. Norfolk Southern's primary competitor is CSX Corporation which covers much of the same territory.
The company operates on 20,141 miles of track out of which 15,493 is owned outright and the remainder is pursuant to trackage rights or leases. Norfolk Southern offers the most extensive intermodal network in the eastern half of the United States.
Norfolk Southern’s business mix includes coal, intermodal, and general merchandise which is composed of six major commodity groupings: automotive; chemicals; metals and construction; agriculture; consumer products, and government; as well as paper, clay, and forest products. Although the company's primary role is transporting freight, its non-carrier subsidiaries engage principally in the acquisition, leasing, and management of coal, oil, gas, and minerals; the development of commercial real estate; telecommunications; and the leasing or sale of rail property and equipment.
Norfolk Southern's earnings depend upon the volume of freight contracts it sells, and the price of those contracts, while its expenses primarily consist of labor, fuel costs, utilities costs, and track maintenance. The largest of Norfolk Southern's customers include steamship lines, vehicle manufacturers, agricultural companies, utilities, intermodal companies, and chemical manufacturers.
We believe the Coal Freight and Intermodal Freight divisions are the most valuable divisions and contribute nearly half of Norfolk Southern's total value. The key factors responsible for this are:
Large volumes of coal freight
Coal, petroleum coke, and iron ore is Norfolk Southern’s largest commodity group and accounts for the highest share of Norfolk Southern's total freight volume, representing nearly 36% of total carloads (excluding intermodal units) in 2013.
- The coal demand in domestic electricity production had been subdued in the recent past as natural gas was favored by many utility companies on account of its environmental friendly properties and cheaper price. However, we expect overall coal volume to grow in the future as natural gas prices should inevitably increase to more normalized levels. The recent increase in natural gas prices in 2013 and decline in coal inventory levels at utilities support our outlook that coal volumes could recover in the future.
- Given Norfolk Southern's exposure to export terminals, the company is well positioned to see strong growth in export coal volumes. We expect the export coal volume to increase substantially due to solid long-term global demand (particularly in Asia)
High incremental margin of Intermodal Freight
The Intermodal Freight business has a strong earnings outlook due to relatively higher incremental margins and firm pricing. With tight truckload capacity, an improving economy and the ongoing corridor projects, which improve capacity as well as increased service, reliability and efficiency will help drive intermodal freight rates higher.
The intermodal segment, although less profitable than coal freight, carries high incremental margins as train lengths are extended, because the additional costs associated with adding containers and trailers to existing trains is low. The recent double-stack initiatives further provides an upside to margins.
Given a strong intermodal growth outlook, Norfolk Southern's EBITDA margin is expected to improve substantially, reaching 42.3% by the end of the Trefis forecast period.
Increasing freight demands and productivity with growing economy
Volumes in the freight industry are highly correlated to macroeconomic conditions. Volumes fall during economic slowdowns, leading to a decline in railroad freight revenues. The ongoing recovery in the U.S. economy and recent rebound in the housing market bode favorably for railroads.
Continued pricing improvements
The pricing power of railroads, with longstanding exemptions from regulation, has been a key factor in Norfolk Southern's success. Railroads have steadily increased rates during the past 10 years primarily through contract renewals and repricing. The company still has some contracts that are outstanding, which should result in healthy price increases. Most rails claim to target long-run 4% to 5% annual price increases, or greater than railroad cost inflation.
How Does Trefis Modelling Work?
How do we get the historical numbers for this chart?
Trefis has a team of in-house Analysts who gather historical data from company filings and other verifiable sources. When historicals are available, we explain how we got them at the bottom of the Trefis analysis section below.
Who came up with the Trefis forecast for future years?
The Trefis team of in-house Analysts considers a variety of factors when projecting any forecast. The rationale for our projections is explained in the Trefis analysis section below.
How does my dragging the trendline on the chart impact the stock price?
- We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.
- We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.
See more on: DCF Methodology
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